Bond Ratings: What are they & how are they decided?

These debt securities are often rated by agencies based on several factors like the financial health and structure of the issuing company.

Publish Date: March 19, 2019

By: Sandhya Kannan, Head – Content

What are bond ratings?

Bond ratings are grades given to bonds so as to indicate their credit quality. Various rating service agencies evaluate the financial strength and the ability of a bond issuer to make timely payments of the principal and interest. Bond ratings range from letters “AAA” being the highest grade to “C” and “D” being the lowest. While these letter ratings are used across rating agencies, a few use them in different combinations of upper and lower cases in order to differentiate themselves.

This rating system helps the investor identify the credit risk of the issuing company. So, if a company is rated higher, it turns out to be a safer investment option. Blue chip companies are a very good example of this. Some of the credit rating agencies in India are Credit Rating Information Services of India Ltd (CRISIL), ICRA Limited, India Rating and Research Pvt. Ltd, Brickwork Ratings (BWR), etc.

Let’s look at some examples of bond ratings:

Rating

Grade

Risk

Aaa/AAA

Investment

Highest Quality

Aa/AA

Investment

High Quality

A

Investment

Strong

Baa/BBB

Investment

Medium Grade

Ba, B/BB, B

Junk

Speculative

Caa/Ca/C/CCC/CC/C

Junk

Highly Speculative

C/D

Junk

In Default

The ratings which are for ‘junk’ bonds are normally for those companies that are in some kind of financial distress. These bonds carry high risk but could also reap higher yields than any other debt instrument. The inherent characteristic of a bond is its security but in some cases, they can be as risky as stocks.

When a rating service looks to rate a company for the bonds it is issuing, they look at the issuer’s debts, assets, liabilities and financial history as well. However, there is one aspect that they pay extra caution to and that is how well does the company rate when they are evaluated on the accountability to repay the bonds on time.

Even though the services are at liberty to carry out checks and reviews of bonds from time to time, whenever they feel the need to, there is also a fixed interval. Rating agencies and services review bond ratings every 6 to 12 months. If there is an out of the regular check done, it will mostly be to check back on any unpaid dues or to evaluate any new developments in the fundamentals of the company.

Why are bond ratings important?

A company issuing bonds having obtained good rating basically indicates that the organization has good financial health. The reasons to follow these ratings are the same that we follow movie and car ratings for; quality and credibility.

A good rating also indicates that the company is capable of paying the obligations it has towards the investors who buy the bond and the related subsidiaries like dividends, debt payments etc.

How are they determined?

To analyse how high or low is the financial risk of a bond issued by a particular company or organization, agencies must look into various parameters. Even though there is no guarantee that investing in a top-rated bond will be risk free, these ratings are a good way to convey the credibility of a company to its aspiring investors in a simple way.

Let’s look at the parameters now!

Financial Health: the rating primary determines this aspect of an issuing company. Rating agencies rely solely on numbers and metrics while evaluating this part of the rating. The agencies also look at the asset and liabilities structure of the company and the collaterals that the company might use in case the need arises.

Capital Structure: it is not carved in stone that all bonds issued by one company will get the same rating. Every bond issued by a company occupies a particular spot within its capital structure and this is another factor that contributes to the rating of a bond. In case the company faces financial problems, these spots will determine which bond repayment will be done first and which will be done at the end and against which collateral.

Upgrades and Downgrades: just as a company keeps adding and subtracting assets and debts from its kitty, changing the financial structure of a company, the ratings also need to be revisited and re-evaluated. Agencies must definitely consider any upgrades or downgrades to reconsider a bond rating.

Even though the bond rating system is in place to advise the investors about the bonds they might invest in, it doesn’t indicate that this is all an investor needs to know. They must always conduct a thorough examination of the instruments they plan to invest in with due diligence. The rating agencies have no legal responsibilities towards the investors and the ratings are just limited to an analysis. So, this can be one of the deciding factors but surely not the only one.

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